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California: The Hell-enic State of America

|Includes: BAC, BCS, C, Goldman Sachs Group Inc. (GS), JPM, MS

On Tuesday, California took a page from the Greek playbook in going after credit default swap players in the midst of its own financial problems.

The State Treasurer Bill Lockyer, sent letters to the biggest banks, Bank of America Merrill Lynch, Barclays, Citigroup, Goldman Sachs, JPMorgan Chase and Morgan Stanley asking for more information about their roles in the market for California credit default swaps.

In the letter Mr. Lockyer writes “I have no preconceived notions about the effect of CDS trading on California bond prices, or about your firm’s activities in the California CDS market……I do, however, worry about firms selling our bonds, on one hand, and trading CDS on our bonds, or otherwise participating in that market, on the other.” Following the usual argument that has gone on since before the Greek crisis, his concern is that such CDS trading is artificially inflating the cost of California’s debt burden. He ends with the reminder that taxpayers have a right to know.

Mr. Lockyer also complained about the CDS of countries like Kazakhstan and Croatia trading  at better levels than California’s CDS. Currently California’s CDS price is around 200 bps while Kazakhstan CDS is around 170 bps and Croatia CDS is around 190 bps.

This relative comparison follows a similar one he made at a previous Assembly Budget Hearing at the end of 2009. In December, Mr. Lockyer had compared California’s cost of debt  at the time (treasury rate+310), as measured by the spread between US Treasury bonds, to countries like Mexico (+185),  Brazil (+172), Philippines (+266) and Indonesia (+286).

Other parts of the presentation (such as the third page of the presentation comparing the state’s general obligation, or GO,  bond spreads to other non-Californian GO bond spreads) probably do a good job identifying the fact that while CDS has increased, so have the actual Californian bond spreads indicating it is not just credit default swap traders or speculators that are driving up California’s debt costs but real money investors, as measured by the investors with cash that actually purchase Californian bonds, have the same concerns as derivative market investors and CDS cannot be solely blamed for issues regarding California’s rising debt costs.

Markets often work to correct pricing imbalances and what often happens is that the under-priced asset increases in price and/or the over priced-asset decreases in price to eliminate the arbitrage opportunities (if there really are any). In this case, the fact that bond prices are also declining lends credence to the real worries about California’s fiscal budget crisis and increasing doubts about its ability to cut costs enough to work its way out. If Europeans expressed doubts about the ability of Greece to actually push through all its proposed austerity measures on its people is any indication, Americans themselves are clearly expressing their skepticism about California’s ability to force austerity measures onto its own residents. Perhaps all those extra convicts out of jail will be enough to generate the GDP necessary to put the state back on track to financial prosperity.

Note: For more information about the bond and credit default swap relationship, CreditLime has previously highlighted the same bond-CDS phenomenon in its series entitled Swap Souvlaki regarding Greek’s financial crisis and the bonds and CDS of Toyota Motor.

Disclosure: long all stocks